History of the Euro

by J. Orlin Grabbe

"I just want to be
good."--Little Alex
(Malcolm McDowell)
in Stanley Kubrick's
A Clockwork Orange.

The "euro" is the name of the
proposed single currency of the
European Community. Essentially the
euro is simply the ECU renamed, since
ECUs will be exchangeable one-for-one
for new euros. The ECU is currently
the basis for the European Monetary
System.

ECU stands for European Currency
Unit, but is pronounced "EK-you", after
the name of an old French coin with an
equivalent spelling. The ECU is
defined in terms of pieces of European
currencies, making it a composite, or
basket, currency in origination. Since
its creation it has become a currency
of denomination for eurobonds and bank
certificates of deposit, among many
other uses.

It is not yet decided whether the
conversion of ECUs to euros will take
place at the market ECU value, or at
the ECU value fixed on paper
(calculated from "ECU central rates").
Logically market rates would be used
for the conversion. But if central
rates are used the conversion is still
straight forward. Suppose at
conversion time the ECU trades for
$1.10 in the market, while the value of
the component currencies at ECU central
rates is $1.08. Then it is obvious
that 1 market ECU = 1.10/1.08 = 1.0185
central rate ECUs. And a euro would
cost $1.10 if euros were exchangeable
one-for-one with market ECUs, or $1.08
if euros were exchangeable one-for-one
for central rate ECUs. The net effect
is that "ECUs" will have been replaced
with "euros".

When the European Monetary System
was launched on March 13, 1979, the
system was based on average behavior of
the participant countries of the
European Community. Average was good;
too much departure from average was
bad. If the community average was 5
percent inflation, then a country with
either 0 percent inflation or 10
percent inflation would cause strains
in the system. All this economic
coordination took place through a
country's exchange rate. A country was
on track just as long as its exchange
rate with respect to the ECU did not
depart too much from a fixed value--the
ECU central rate. (Details of this
mechanism may be found in Chapter 2 and
Chapter 22, International Financial
Markets, 3rd edition, by J. Orlin
Grabbe.) The Maastricht Treaty added
additional criteria other than exchange
rates.

The Maastricht Treaty was finally
approved (through a subterfuge) by the
remaining holdout, Denmark, in May
1993. The Treaty set out three stages
of further transition to monetary union
between participant countries of the
European Community. The first stage
was to have been completed by Jan. 1,
1994, and involved the elimination of
"all restrictions on the movement of
capital between Member States, and
between Member States and third
countries". This goal was not actually
achieved.

The second stage began on Jan. 1,
1994, with the creation of the European
Monetary Institute (EMI) in Frankfurt,
Germany. The EMI was a precursor to a
proposed European Central Bank, which
in the future is supposed to implement
a common European monetary policy,
conduct foreign exchange operations,
hold reserves of member countries, and
promote smooth payment mechanisms. The
goals of the EMI itself were more
modest. The EMI was supposed to hold
the gold and foreign exchange reserves,
and oversee the operation, of the
European Monetary System, and to
promote the use of the ECU and an ECU
clearing system.

How to Be Good

Meanwhile, the EMI is also
supposed to monitor some other economic
convergence criteria among member
countries, which included not only
exchange rates, but also inflation,
government debt, and interest rates.
To be "good", and thus to be allowed to
joined the new monetary union in 1999,
countries need to have done the
following by end 1997:

to have kept its currency within
the normal margins around its fixed
value in terms of the ECU and to have
not devalued against any other member
country for two years;

to have "price stability", which
is defined as having a rate of
inflation of the consumer price index
not more than 1.5 percent points about
the three member countries with the
lowest inflation rates;

to have a government deficit that
is not "excessive", which is defined as
a) a government deficit that doesn't
exceed 3 percent of yearly gross
domestic product; and b) the value of
outstanding government debt doesn't
exceed 60 percent of yearly gross
domestic product;

to have long-term interest rates
(ten-year government bond rates) not
more than 2 percent above the three
member countries with the lowest rates
of inflation.

Except for the criteria on
government debt, each of these again
rests on the concept of an average.
But meeting the criteria has led to
considerable activity in the area of
government statistics fudging. How much
fudging is allowed is up to the EMI and
the European Commission to decide.

For example, France (much like the
U.S. in another context) counted a
current pension fund "surplus" as
government income, thus reducing the
calculated government deficit. Of
course, just as in the U.S., the
current year's "surplus" did not take
account of future obligations (on which
basis the flow of pension funds was
actually insufficient--that is, in
deficit). But this hardly matters,
since both France and Germany have to
be in the union, if it is to take place
at all (see history in International
Financial Markets). Germany envisions
that the new European Central Bank will
conduct policy much like the
Bundesbank, but the French have other
ideas.

The third stage is supposed to
come about on Jan. 1, 1999, at which
time countries will irrevocably fix
their currencies to the euro (=ECU),
after which national currencies will be
phased out during a transition period.
During transition, the euro and the
national currency will circulate side
by side. The EMI will be dissolved
into a European Central Bank (ECB),
which will determine a common monetary
policy. Government bonds will be
denominated in euros, and some
countries, like France, will convert
existing debt to euros. The current
head of the central bank of the
Netherlands, Wim Duisenberg, is
expected to become the first president
of the ECB.

During a three-year transition
period, 1999-2002, European companies
will convert their accounts to euros.
Then, in 2002, euro notes and coins
will be circulated in the different
countries. There will, of course, be
much bickering over the use of national
symbols (should the queen's head be
conjoined with the body of a bird?),
or whether coin sizes will fit into
national telephones and vending
machines.

Will all this actually happen?
The answer is not clear, even this
close to the scheduled date. A critical
mass of participants is required for
anything significant to take place.
Luxembourg, for example, fits the bill
for monetary union with no problem.
But there is strong political
opposition to the move in countries
like the UK and Denmark. And it will
be a cold day in hell before either
Italy or Greece meets the convergence
criteria.

Recent years have witnessed a
period of unprecedented good will
between nations: the fall of the Berlin
Wall, the dissolution of the Soviet
Union, relative Middle East peace, and
so on. One senses, however, that this
era of good will is rapidly coming to a
close. Looming over the horizon are
conflicts between the U.S., China, and
Japan, turmoil in Russia, and another
war in the Middle East. All these will
exert their strains on the European
Community and on monetary union.

The movement toward European
unification began with a post-World War
II desire of people like Jean Monnet
and Robert Schuman to so integrate the
economies of Germany and France that
they could never go to war again.
Early trade agreements led to exchange
rate agreements, and these have evolved
into agreements on broad economic
convergence criteria. The final
process of unification, of course,
would be integrated defense departments-
-a step not currently in the offing.

Natural Disasters

One recent focus of attention has
been the nature of punishments to be
meted out to bad countries. At the
European Union (EU) meeting in Dublin
in Dec. 1996, it was decided that
countries with government deficits too
large would not be punished in the
event of a "natural disaster" or if
gross domestic product (GDP) had a
negative growth rate of more than 2
percent. It was observed that among
the 15 EU countries, there had only
been negative growth rates that large
in 13 instances in the last 30 years
(i.e. in 13 observations out of 450).

If negative GDP rates are between
negative .75 and negative 2.00, then
European finance ministers will decide
whether a country is to be punished.
(There was no determination of what the
punishment will be, but public flogging
of the finance minister or penalty
payments of central bank gold come to
mind.)

A combination of a government
deficit larger than 3 percent of GDP
combined with a positive GDP growth
rate, or a negative growth rate not
exceeding .75 in absolute value, would
result in automatic punishments. This
agreement is seen as a victory for
Germany, as France wanted maximum
political discretion to punish or not
to punish.

Coming Soon: "The End of Ordinary
Money, Part III: Anonymous Digital Cash
in Theory and Practice".